CHAPTER 2

SOLUTIONS TO PROBLEMS 2.1 (i) Income, age, and family background (such as number of siblings) are just a few possibilities. It seems that each of these could be correlated with years of education. (Income and education are probably positively correlated; age and education may be negatively correlated because women in more recent cohorts have, on average, more education; and number of siblings and education are probably negatively correlated.) (ii) Not if the factors we listed in part (i) are correlated with educ. Because we would like to hold these factors fixed, they are part of the error term. But if u is correlated with educ then E(u| educ) 0, and so SLR.4 fails. 2.3 (i) Let yi = GPAi, xi = ACTi, and n = 8. Then x = 25.875, y = 3.2125, (xi x )(yi y ) =
i=1 n

5.8125, and (xi x )2 = 56.875. From equation (2.9), we obtain the slope as 1 =
i=1

5.8125/56.875 .1022, rounded to four places after the decimal. From (2.17), 0 = y 1 x 3.2125 (.1022)25.875 .5681. So we can write GPA = .5681 + .1022 ACT n = 8. The intercept does not have a useful interpretation because ACT is not close to zero for the population of interest. If ACT is 5 points higher, GPA increases by .1022(5) = .511. (ii) The fitted values and residuals rounded to four decimal places are given along with the observation number i and GPA in the following table: GP i A 1 2.8 2 3.4 3 3.0 4 3.5 5 3.6 6 3.0 7 2.7 8 3.7 GPA 2.7143 3.0209 3.3275 3.5319 u .0857 .3791 .1725 .0681

3.2253 .2253

3.1231 .1231 3.1231 .4231 3.6341 .0659

You can verify that the residuals, as reported in the table, sum to .0002, which is pretty close to zero given the inherent rounding error. (iii) When ACT = 20, GPA = .5681 + .1022(20) 2.61. (iv) The sum of squared residuals, the total sum of squares, u
i =1 n 2 i

, is about .4347 (rounded to four decimal places), and

(yi y )2, is about 1.0288. So the R-squared from the regression is

i= 1

R2 = 1 SSR/SST 1 (.4347/1.0288) .577. Therefore, about 57.7% of the variation in GPA is explained by ACT in this small sample of students. 2.5 (i) The intercept implies that when inc = 0, cons is predicted to be negative $124.84. This, of course, cannot be true, and reflects that fact that this consumption function might be a poor predictor of consumption at very low-income levels. On the other hand, on an annual basis, $124.84 is not so far from zero. (ii) Just plug 30,000 into the equation: cons = 124.84 + .853(30,000) = 25,465.16 dollars. (iii) The MPC and the APC are shown in the following graph. Even though the intercept is negative, the smallest APC in the sample is positive. The graph starts at an annual income level of $1,000 (in 1970 dollars).

MPC APC

.9

MPC
.853

APC

.728 .7 1000
10000

20000

30000

inc

2.7 (i) When we condition on inc in computing an expectation, inc becomes a constant. So E(u| inc) = E( inc e|inc) = inc E(e|inc) = inc 0 because E(e|inc) = E(e) = 0. (ii) Again, when we condition on inc in computing a variance, inc becomes a constant. So Var(u|inc) = Var( inc e|inc) = ( inc )2Var(e|inc) = e2 inc because Var(e|inc) = e2 . (iii) Families with low incomes do not have much discretion about spending; typically, a lowincome family must spend on food, clothing, housing, and other necessities. Higher income people have more discretion, and some might choose more consumption while others more saving. This discretion suggests wider variability in saving among higher income families. 2.9 (i) We follow the hint, noting that c1 y = c1 y (the sample average of c1 yi is c1 times the sample average of yi) and c2 x = c2 x . When we regress c1yi on c2xi (including an intercept) we use equation (2.19) to obtain the slope:

% 1 =

(c2 xi c2 x)(c1 yi c1 y )
i =1

(c2 xi c2 x )2
i =1 n

c c ( x x )( y y )
i =1 1 2 n i i

c (x x )
i =1 2 2 i

c = 1 i =1 c2

( xi x )( yi y )

(x x )
i =1 i

c1 1. c2

% % From (2.17), we obtain the intercept as 0 = (c1 y ) 1 (c2 x ) = (c1 y ) [(c1/c2) 1 ](c2 x ) = c1( y x ) = c1 ) because the intercept from regressing yi on xi is ( y x ).
1 0 1

(ii) We use the same approach from part (i) along with the fact that (c1 + y ) = c1 + y and (c2 + x ) = c2 + x . Therefore, (c1 + yi ) (c1 + y ) = (c1 + yi) (c1 + y ) = yi y and (c2 + xi) (c2 + x ) = xi x . So c1 and c2 entirely drop out of the slope formula for the regression of (c1 + yi) % % % on (c2 + xi), and = . The intercept is = (c + y ) (c + x) = (c1 + y ) (c2 + x ) = (
1 1 0 1 1 2 1

y 1 x ) + c1 c2 1 = 0 + c1 c2 1 , which is what we wanted to show. (iii) We can simply apply part (ii) because log(c1 yi ) = log(c1 ) + log( yi ) . In other words, replace c1 with log(c1), yi with log(yi), and set c2 = 0. (iv) Again, we can apply part (ii) with c1 = 0 and replacing c2 with log(c2) and xi with log(xi). If and are the original intercept and slope, then = and = log(c ) . % % 0 1 1 1 0 0 2 1 2.11 (i) We would want to randomly assign the number of hours in the preparation course so that hours is independent of other factors that affect performance on the SAT. Then, we would collect information on SAT score for each student in the experiment, yielding a data set {( sati , hoursi ) : i = 1,..., n} , where n is the number of students we can afford to have in the study. From equation (2.7), we should try to get as much variation in hoursi as is feasible. (ii) Here are three factors: innate ability, family income, and general health on the day of the exam. If we think students with higher native intelligence think they do not need to prepare for the SAT, then ability and hours will be negatively correlated. Family income would probably be positively correlated with hours, because higher income families can more easily afford preparation courses. Ruling out chronic health problems, health on the day of the exam should be roughly uncorrelated with hours spent in a preparation course. (iii) If preparation courses are effective, 1 should be positive: other factors equal, an increase in hours should increase sat. (iv) The intercept, 0 , has a useful interpretation in this example: because E(u) = 0, 0 is the average SAT score for students in the population with hours = 0. 6

SOLUTIONS TO COMPUTER EXERCISES C2.1 (i) The average prate is about 87.36 and the average mrate is about .732. (ii) The estimated equation is prate = 83.05 + 5.86 mrate n = 1,534, R2 = .075. (iii) The intercept implies that, even if mrate = 0, the predicted participation rate is 83.05 percent. The coefficient on mrate implies that a one-dollar increase in the match rate a fairly large increase is estimated to increase prate by 5.86 percentage points. This assumes, of course, that this change prate is possible (if, say, prate is already at 98, this interpretation makes no sense). (iv) If we plug mrate = 3.5 into the equation we get prate = 83.05 + 5.86(3.5) = 103.59. This is impossible, as we can have at most a 100 percent participation rate. This illustrates that, especially when dependent variables are bounded, a simple regression model can give strange predictions for extreme values of the independent variable. (In the sample of 1,534 firms, only 34 have mrate 3.5.) (v) mrate explains about 7.5% of the variation in prate. This is not much, and suggests that many other factors influence 401(k) plan participation rates. C2.3 (i) The estimated equation is sleep = 3,586.4 .151 totwrk n = 706, R2 = .103. The intercept implies that the estimated amount of sleep per week for someone who does not work is 3,586.4 minutes, or about 59.77 hours. This comes to about 8.5 hours per night. (ii) If someone works two more hours per week then totwrk = 120 (because totwrk is measured in minutes), and so sleep = .151(120) = 18.12 minutes. This is only a few minutes a night. If someone were to work one more hour on each of five working days, sleep = .151(300) = 45.3 minutes, or about five minutes a night. C2.5 (i) The constant elasticity model is a log-log model: log(rd) = 0 + 1 log(sales) + u, where 1 is the elasticity of rd with respect to sales.

(ii) The estimated equation is log(rd ) = 4.105 + 1.076 log(sales) n = 32, R2 = .910. The estimated elasticity of rd with respect to sales is 1.076, which is just above one. A one percent increase in sales is estimated to increase rd by about 1.08%. C2.7 (i) The average gift is about 7.44 Dutch guilders. Out of 4,268 respondents, 2,561 did not give a gift, or about 60 percent. (ii) The average mailings per year is about 2.05. The minimum value is .25 (which presumably means that someone has been on the mailing list for at least four years) and the maximum value is 3.5. (iii) The estimated equation is gift = 2.01 + 2.65 mailsyear n = 4,268, R 2 = .0138 (iv) The slope coefficient from part (iii) means that each mailing per year is associated with perhaps even causes an estimated 2.65 additional guilders, on average. Therefore, if each mailing costs one guilder, the expected profit from each mailing is estimated to be 1.65 guilders. This is only the average, however. Some mailings generate no contributions, or a contribution less than the mailing cost; other mailings generated much more than the mailing cost. (v) Because the smallest mailsyear in the sample is .25, the smallest predicted value of gifts is 2.01 + 2.65(.25) 2.67. Even if we look at the overall population, where some people have received no mailings, the smallest predicted value is about two. So, with this estimated equation, we never predict zero charitable gifts.